What is an Independent Contractor?

Benefits and Drawbacks of Being an Independent Contractor

Confused about being an independent contractor? Maybe you are working as an employee and you want to go off on your own and work independently. Or maybe your company has suggested that you could work at home, and they want to change your status to being an independent contractor.

Before you make this change, you should know about some of the pros and cons of working independently.

What Does it Mean to Be an Independent Contractor?

An independent contractor is an individual in business who provides services to another individual or business.

The independent contractor is a separate business entity and is not considered an employee. Some independent contractors are consultants, agents, or brokers. Others might be creative professionals or technical/IT types.

Benefits of Being an Independent Contractor

1. Being Independent. It sounds obvious, but that's probably why you are considering this change. As an independent contractor, you don't have to work for someone else. You may be able to set your own hours and complete work assignments whenever you choose, depending on the type of job. You should be able to negotiate pay rates and a payment schedule, but you may still have to keep a time sheet if you are working on an hourly rate.

2. No Tax Withholding. Some people consider it a benefit that the payments you receive as an independent contractor don't have federal or state income tax withheld, and no FICA taxes (Social Security and Medicare taxes) are withheld.

But you must still pay these taxes on your personal income tax return (see the tax drawbacks, below).

3. Getting a Contract. Most employees don't have a written contract unless they work under a union contract or are highly paid executives. But an independent contractor can always have a contract. It's a good idea to get a written contract from each person or business you work for.

Having a contract spells out "what happens when." For example, it defines when the contract is over, what happens if one party wants out, and what if one party can't fulfill its obligations. Having a contract can settle many disputes before they start, and you can take a contract to court to get paid, if necessary.

4. Deducting business expenses. All the expenses you must pay to run your independent contractor business are deductible to you as business expenses. That includes business travel and the costs involved with having a home-based business. Of course, you'll have to file a business tax return to get the deductions, but it's worth it to minimize your income - and income taxes.

Drawbacks of Being an Independent Contractor

1. No Guarantee of Income. Being independent also means you don't get a regular paycheck. If you are lucky enough to work for one or more clients who pay you regularly, that's great. But the money can stop at any time, even if you have a contract. If there's no work for you to do, there's no money.

2. Paying Business Expenses. If you work for someone else, they provide the office and the computer and everything else that goes with it. While you can deduct these expenses, you still must have the money to pay for them first.

Some business expenses may not be deductible, and some may be deductible only on a limited basis. For example, meal and entertainment expenses are only deductible at 50% of the amount. If you work from home, you can save money on some of these expenses.

3. No Benefit Plans. One of the main reasons people stay as employees is to have employee benefits, like health care, paid for by their employers. If you need health insurance, you can get it if you work independently, but you will have to pay for it. That's a tough decision to make. You can find health care coverage for self-employed individuals, including Obamacare.

4. You Still Must Pay Taxes. As an independent contractor, you will still have to declare all the income from your work and you still must pay taxes on that income. In addition to paying federal and state income taxes, you must also pay those Social Security and Medicare taxes (in this case, it's called "self-employment taxes.")

Since no taxes have been withheld from your payments, you must pay these taxes by the tax deadline (April 15), along with your personal income tax return. If you haven't paid enough taxes during the year, you might need to make estimated tax payments throughout the year.

What You Can Get as Both an Employee or Independent Contractor

Employees and self-employed individuals can both contribute to retirement savings accounts. Employees can contribute through their employers. If you are an independent contractor, you can find a retirement savings plan that fits your needs.

Talk to Your Tax and Legal Advisors Before Becoming an Independent Contractor

Before you make that leap to leaving employee status and becoming an independent contractor, discuss the benefits and drawbacks and all issues with your tax and legal advisors.